Hard Brexit

One of the truisms of modern politics in the U.K. is no one is surprised by anything. Not the confidence vote in Theresa May, not the postponing of Parliament’s vote on the withdrawal agreement, and certainly a general election in the near future would not be surprising. Since 2016 at least, it as often felt like we have entered ‘the twilight zone’, where any outcome is believable, and all bets are off. So, for those who have not been following the ins and outs of British politics, there might be cause both for a quick recap of where we in the U.K. have got to, and for a pause for breath, as we consider how the next year of Brexit may well play out. And let me lay it out at the start: nothing would surprise me.

How we got here is a long story, but it can be summed up in a few key dates. Clearly, the referendum of June 23, 2016, when the U.K. voted to leave the European Union, is among them. Next of course would be March 29, 2017, when the official notification that the U.K. would be leaving the EU was submitted under Article 50 of the Treaty on European Union, starting the two-year countdown. Then June 8, 2017, when Theresa May lost her narrow parliamentary majority in a snap election that she had no need to call (and having enjoyed a 20-point lead going into the last weeks of campaigning).

When the history of Brexit is written however, Dec. 8, 2017, might be considered the most crucial. This was the date on which the U.K. and EU teams published their joint report on progress in negotiations, and it was this that largely set the parameters which have determined the negotiations since. Most particularly, the U.K. agreed in principle here both the so called ‘divorce bill’ of £39 billion, and the even more contentious Irish Backstop. This was where, in the absence of agreed solutions, the U.K. committed to “maintain full alignment with those rules of the Internal Market and the Customs Union which, now or in future, support North-South cooperation, the all-island economy and the protection of the 1998 Agreement.” In effect, the U.K. had made itself responsible for both sides of the border in all future negotiations.

When the U.K. failed to contest this interpretation of the joint report, we boarded the Brexit rollercoaster that took us through Chequers 1, 2 & 3 (where the cabinet debated what they wanted from the exit terms and future relationship with the EU), intensive and secretive negotiations between the U.K. and EU, leading us to the draft withdrawal agreement that the U.K. and EU published on Nov. 14 of last year. There may have been twists and turns along the route, but the end result always looked to be a customs union and with high regulatory alignment as a backstop to ensure no hard border on the island of Ireland, pending a future agreement to be negotiated that would “build and improve upon” these arrangements. And such a result was always going to be highly contentious in parliament.

How much of these developments were down to U.K. incompetence, conspiracy, or the inevitable difficulties of the negotiations given the parties starting points depends on whom you ask. Personally, I am suspicious of both the conspiracy narrative, and the notion that these things are purely deterministic. Either way, we have now reached the “end of the track.” The pre-scripted part of Brexit, if there was one, is over; what happens now will be determined by political decisions.

At least in the media, all options are on the table. Some favour so called “Norway +,” which might actually be termed “Norway –” as it involves staying in a customs union; others would prefer a second referendum, although how to achieve one without a general election seems a mystery.

The prime minister’s withdrawal agreement, hated by parliament as it is, is still alive. But were I to offer my two cents, the only option ahead with a clear path, and requiring no new legislation in parliament, is some form of ‘Hard Brexit.’ As such, it is increasingly important to consider what such an outcome might comprise.

By Hard Brexit I mean the U.K. leaving the EU on March 29 without a withdrawal agreement. Unlike most other options, this does not require the cooperation of the EU to proceed. In this scenario, the U.K. leaves both Single Market and Customs Union of the European Union at 11 p.m. on March 29, 2019, along with leaving the various political institutions of the EU and the jurisdiction of the Court of Justice of the EU. Because cooperation with the EU is not taken for granted here, the potential for disruption, from aircraft landing rights to derivatives contracts and the supply of medical isotopes, is massive. World Trade Organisation (WTO) rules are relatively limited in scope and do not address many of the most difficult issues concerning non-tariff barriers, border frictions and services trade.

There remain, however, a large number of mitigating actions that can be taken unilaterally, while many of the more alarming warnings of no cooperation at all can be dismissed as fanciful. A more believable ‘no deal’ Brexit might look as follows.

Firstly, planes will continue to fly. The U.K. possesses the world’s third largest aviation network and the European Commission has already confirmed that it will take steps to ensure that air services will continue. Major airlines clearly accept this and have been selling post Brexit tickets for months. The same is true of other areas where outright non-cooperation would be damaging. At the time of writing, the Commission is doing all it can to publicly rule out this sort of “managed no deal,” yet in doing so has stated that it would unilaterally extend agreements in selected sectors, including for financial services, following a WTO exit.

Although the Commission has urged member states to refrain from exercising their national powers to make bilateral agreements with the U.K., one could reasonably expect further agreements, possibly at the 11th hour in March or shortly following an exit on WTO terms as described above. These would likely cover citizens’ rights, road haulage, and facilitated customs checks for certain classes of goods, and would be negotiated with the member states with which the U.K. does the most business. In the most optimistic scenario, the U.K. and EU strike a last-minute agreement to begin full free trade agreement (FTA) negotiations, under Article 24 of the WTO General Agreement on Tariffs and Trade. This would allow for provisional tariff free access for UK goods into the EU market. In reality, triggering Article 24 would require fairly advanced plans for such an agreement, and so it is more likely that U.K. goods would face tariffs exporting to the EU 27. However, on average, such tariffs are relatively low for non-agricultural goods and could easily be compensated by an expected devaluation of the pound. The issue is non-tariff barriers and administrative costs and frictions. There are good arguments that the EU would be in violation of WTO rules by imposing full third-country regulatory controls on U.K. goods, while our respective regulations remain the same, but this would not be quick or easy to resolve. Northern Irish traders exporting to their neighbors in the Republic of Ireland would be particularly hard hit, if the EU maintained its current course, even if the U.K. government stood by its pledge not to introduce border infrastructure.

But it Is worth bearing in mind here just how much the U.K.’s economic success depends on actions taken in Britain. While the EU accounts for over 40 percent of U.K. trade, imports are a significantly larger part than exports (£341 billion vs £247 billion). How these are treated will be down to us, and the government has already promised to continue recognising EU standards in sectors such as medicines. EU exports on their own still comprise between 13 percent and 14 percent of the economy as a whole, however much of this takes place in services, where Single Market provisions are patchy. In fact, before leaving became an explosive political issue, most analyses of the costs and benefits of the U.K. leaving were pretty much a wash. Estimates were plus or minus one or two percentage points of GDP; a far cry from recent pronouncements from the Treasury. Even so, there will still be significant opportunities available as a result of leaving the EU that would benefit the U.K. economy.

The first of these actions is to move quickly towards unilateral free trade, particularly in sectors where the U.K. is a net importer. If you had been paying attention to debates in Parliament, you might have gained the impression that the U.K. economy depends primarily on cars and fish. In reality, these two sectors added together constitute less than 1 percent of U.K. GDP. The same is also true of agriculture, and other high tariff sectors such as clothing and footwear are likewise small segments of the U.K. economy. Reducing these tariff barriers has long been hailed as one of the key potential benefits of Brexit. Such a move would lower prices for consumers and reduce the cost of inputs for other sectors of the economy.

The second set of reforms that would be enabled by leaving involve the replacement or repeal of various EU rules. Using the governments own impact assessments, the cost of EU regulation on the U.K. economy easily runs into the tens of billions of pounds annually. Many expensive rules on financial services, such as CRD IV and AIFMD, and certain aspects of environmental and labour law should be reformed or repealed if the U.K. is to become more competitive. These laws can also be more damaging than the significant costs make them appear due to anti-competitive effects on small and start-up businesses that are almost impossible to capture.

Ultimately, the most significant factor will be domestic policy decisions by the U.K. government, particularly in areas of taxation and housing. This may be fairly unexciting news at the end of an article about Brexit, but if the U.K. is to succeed as a “free trading, buccaneering nation,” such success will depend in large part on the ability of companies to attract investment through low corporate taxes, and the ability of workers to move to where they will be most productive through further housebuilding in key areas.

The objection to such calls has always been that it is not politically feasible. Interestingly though, and perhaps as an unexpected consequence of the conversation surrounding Brexit, that may be changing. A recent ComRes poll found that, although divided on almost every other aspect, a clear two thirds of voters agree that when Brexit is complete, “the U.K. should try to become the lowest tax, business-friendliest country in Europe, focused on building strong international trade links.” Against all expectations, the view is even held by a majority of Labour voters (54 percent). Might the country be prepared to embark on a pro-free trade, lower tax and de-regulatory agenda? Well, as I said at the start, nothing would surprise me.